Ratings of investment vehicles are one factor commonly used by investors and financial advisors in determining how to invest. These ratings are typically divided into various types of investments, such as funds with particular investment objectives or types of holdings. Ratings are generally based on past returns. However, investors and their financial advisors are seeking information about future performance, not past performance, of investment vehicles. As a result, existing ratings are limited in their usefulness.
Futures provide information on expected future returns in various investment areas or asset classes. For example, a financial future on the S&P 500 for the period ending June 2007 is a representation of what the financial markets expect the value of the S&P 500 will be in June 2007. Financial futures are now available for a number of segments of the market, such as US value stocks, US growth stocks, small capitalization stocks, large capitalization stocks, US Treasury Bonds, high yields bonds, etc. By combining information on the Funds with the expected range of future returns, as implied by the pricing of the Futures, one can derive a range of expected future returns, the volatility of future returns, and a rating, which reflects the expected return and the risk of the Fund.
Expanding on the example of the S&P 500 future and a large capitalization mutual fund, whereby the future indicated that the expected return was an annualized 7%. Using a modification of the Black-Scholes (a widely used option pricing equation developed in 1973 by Fisher Black and Myron Scholes used to price OTC options), one could determine that there was a 66% chance that the return would be within 5 and 9% and a 95% chance that the return would be within 4 and 10% for the period ending June 2007. If the Fund had a historic return that was on average 1% less than the S&P 500, but with the same level of volatility, then the mean expected return would be 6%, and the range of expected returns at the 66% level of confidence would be 4 to 8% (i.e., 1% less than the example with the S&P 500). In the same way, the range of returns at the 95% confidence level would be 3 to 9% (i.e., 1% less than the example with the S&P 500).
In assigning ratings, the expected future return and volatility of future return is compared to that of other investment classes. For example, if large capitalization funds were expected to return 7% with a 4% range at the 66% confidence level, compared to a South American equity fund with an expected return of 5% and a range of 4% at the 66% probability level, the South American sector would be less appealing and therefore have a weaker rating. Note, the relative returns of the Fund are incorporated into the expected future return for the sector in deriving ratings. The Rating represents the expected risk and reward.
Note, the Black-Scholes model is useful for pricing options, whereas futures pricing can be used to determine the expected future returns for various investment areas, and a combination of futures pricing information the relative performance of a fund and other information such as capability assessment of investment managers, support staff and characteristics of portfolio securities to derive a rating. With existing practices, firms can operate to rate Funds use mainly historical returns in assigning ratings.
From the foregoing it is appreciated that there exists a need for a new platform that ameliorates the shortcomings of existing practices.